“Follow the trend” is one of the most popular and yet best advice for any new trader on the market. You can always try to outplay the trend or trade in the opposite direction but in the end, you will always lose if you won’t take into account current tendencies on the market or separate assets.
Most trading strategies on the market are based on finding a current trend, its support and resistance points, and the best entries. Because of the nature of the market, the most profitable traders are the ones who follow the trend. For example, once you’ve found out that the trend is changing you will be able to open a position a receive massive gains until you receive an exit signal by your trading strategy.
What is a trend trading strategy?
First of all, let’s figure out what’s the trend on the market. Trends are market tendencies that usually are being reflected on a chart as progressive price movements in one direction: up or down. In some cases, you will be able to witness a rangebound trend – a tendency where the market remains uncertain in which way to go.
It’s hard to not notice a strong tendency on the market whether it’s a down or an uptrend but sometimes it might be tricky to follow an unclear movement on the market or to find any trend at all. Just as we can see here, for example:
For instances like that, you will have to use some indicators or a trading system that will help you to tell if the marketing is trending or not. If you choose to trade in the ranging markets you will almost guarantee to lose money in it even you choose to open a short position in it.
Trend trading strategies are a set of various technical and fundamental analysis tools that allows you to determine:
a) Whether the market is trending or not
b) In what direction market moves right now
c) When the up or downtrend is over
Trend strategies are the most popular type of strategies on the market which actually makes it more sufficient since more people follow the trend = stronger it gets. Depending on the style that you trade with you will use the trend strategies differently.
If you’re a short-term trader your strategy will mostly be aimed at finding points of trend reversal where you can buy the asset, follow the trend and collect your profits in one trading session.
Mid-term traders are the ones who are utilizing trend trading strategies at full potential. They are looking for entries, finding the current trend, and following trend indicators to form their multi-sessional positions on the market.
Long-term traders and investors are mostly using trend trading strategies to see if the market is currently moving in the uptrend on long-term timeframes like 1 week or even 1 month. Since fund managers are not allowed to open short positions they have to look at the assets that move in an uptrend direction.
Main benefits of trend trading strategy
As you’ve probably found out there’s a lot of usage for trend trading strategy even if you are not planning on looking at the stock charts on daily basis. But just to clarify let’s isolate the main advantages of following the trend:
First: Highest profits.
Some brokers might always try to convince you about how good and profitable it is to scalp on 1-min timeframes or buying stocks in the range markets because it might be the accumulation period but the highest profit that you can get is always tailored to the trend that is going on the asset that you are trading.
If you enter the position right at the beginning of the strong uptrend you will be able to receive more than 30% profit in a 2-3 months timeframe on average.
Second: Safest way to make money on stock market.
Yes, you heard us right: following the trend is the safest way to make money while trading. Since you are following the general tendencies on the market it’s really hard to lose money. You wouldn’t like to bet on the horse with 3 legs in the race against healthy horses. Same with the following trend: you wouldn’t like to buy a stock, commodity or even a currency while it’s going down for some reason.
But don’t rush on the stock market and buy everything that grows. Trends are called trends for a reason. All trends eventually end and reverse. For that exact case, you need a strategy that will help you to avoid trend reversal and will save your money.
Third: Most strategies on the market are trend strategies.
Sometimes it can be frustrating to find a good trading strategy. Some people spend thousands of hours and dollars just to find something or someone who will show them the right way to trade on the stock market. But don’t worry. If you choose to follow a trend strategy you won’t have any problems with finding a decent trading strategy that will give you at least 20% of annual returns.
Building a trend following trading strategy
To build a good trading strategy to use in trending markets you will have to solve a couple of problems. After that, you will have the ready-to-use trading strategies that will help you to become successful in the stock or forex market.
Problem #1: How to define a trend and find support and resistance zones?
There are many tools and ways to define a current trend on the market. We will start from the basics that can be used without any indicators and knowledge.
As you can see on the chart in the uptrend movement you should always see higher highs and higher lows. Once a lower high being formed the trend can be considered reversed. In that case, you will have general knowledge about the current trend movement.
In order to define the current trend on the position, you will have to follow the general price movement or rely on some indicators. Usually, the mentioned method of using highs and lows works almost perfectly but sometimes it gives us false signals about the change of the trend while it actually consolidates or just slowing a bit. In order to avoid getting false signals traders to use various indicators that allow you to easily define the current trend by just looking at the value of the indicator or its placement on the chart. Here are the most popular indicators for defining a trend’s direction:
MACD Indicator
MACD is one of the most popular trend finder indicator among trend traders. It’s being widely used for both trend defining and entry selection.
MACD shows you two moving averages with periods of 26 and 12. If you choose to use MACD as an entry indicator you will buy when the 12-period (blue on the chart) line crosses the 26-period line. In such cases indicator shows us that the faster-moving average of the price is higher than the slower moving average of the price which gives us an early signal of the trend reversal. Once a trend is losing its strength you will see an opposite cross that will be a signal for you to close your position.
But MACD has multiple uses. With MACD you will be able to see the current strength of the trend by looking at the so-called histogram. Green and red bars on the indicators signalize the current trend strength by using the difference between the signal line and the MACD line itself. Once you see lower candles appearing on the histogram it will become a signal of a trend weakening. Traders use that signal to hedge or close their positions once they see a risk of a trend reversal.
Generally, MACD can easily find a place in your trend following trading strategy since it has multiple usages and works almost on any chart and position. MACD can be used on both short and long-term timeframes with the same efficiency.
Exponential and simple moving average
Moving averages are fundamental indicators of the trend following strategies since they show you the average price on the specified period of time like 10, 50, 200 days, etc. Moving averages or simply MAs are being used almost in any indicator out there. The reason is simple – technical analysis is based on the previous price movements and moving averages are the perfect reflection of the movement history.
How can you use moving averages? There are many uses for MAs in technical analysis:
Trend defining – for that matter you will need one or sometimes two moving averages. Usually, traders rely on the 200-day moving average as the main trend direction indicator. If the price remains above the line it means that the current trend is bullish and visa-versa.
In addition to using one line for defining the trend on the price chart, you can add up another moving average with, let’s say, a period of 50. Once you see the crossover of those lines you will know that the long-term trend has changed.
Support and resistance zones.
Moving averages can also act as strong resistance and support zones on the chart. If you look almost at any chart with uptrend tendency you will instantly see that price is constantly “testing” the moving average and then bouncing back up from them.
Usually, the more tests you see on the moving average stronger it gets since traders trust it more and put buy orders at the price range of the closes moving average. But sometimes it might not be a good idea to buy “from” the moving average especially if the price rapidly going down in its direction. The general rule “don’t buy in the downtrend” even if it’s a local one still applies here.
Trend strength indicator
Usually to define the strength of the trend traders use different indicators like MACD, Volume, and others. But you can see if the trend is unstable by using multiple moving averages that are usually being called ribbons. To use ribbons you will have to put use around 10 lines on your chart. Once traders see the ribbons are becoming too loose that will receive the general knowledge about current instability on the market and most likely hedge their position.
But there’s no magic here and ribbons just act on the general volatility on the position. Volatility is the changeability of the price of the assets. For example usual volatility for ABC stock is 2% daily which means it usually moves for 0-2% per day in either direction. Once ABC makes a move that exceeds 2% growth or fall we can tell that we are witnessing elevated volatility on the position.
If volatility is constantly increasing market will most likely stabilize itself and change the up or downtrend to a rangebound market.
Setting up the moving average
As we have mentioned there are different settings for moving average that can completely change the way they work and the information that they show.
The most popular setting is the “period” or also known as “argument” which is basically a value that is being used to determine the place of the line on the chart.
The most popular periods to use are 50 and 200. Some traders also use short-term moving averages which is a set of indicators with low-timeframe periods like 7, 10, 12, 21 and etc. Those sometimes can be used as the first supports for the price that moves in a specific direction of the trend.
Exponential moving averages are basically simple moving averages on steroids that have implemented formulas to make their movement look more relevant to the price. In addition to the simple moving average formula, we add up the weighted multiplier that tracks the price trends over time. Sometimes it’s indeed better to use EMAs instead of MAs especially for the longer periods of 50 and 200, but if you choose to use the short-term moving average there’s no need to make them exponential since it won’t give you any additional information that might or might not help you.
Problem #2 How to find a good entry or trend reversal
Moving averages can be an ultimate indicator for any trend trader but it’s not always the most useful tool on the market. For that instance, professional traders and economists have come up with indicators that will help you to see when to exit and enter any position on the market.
RSI is another trend trading tool that’s being widely used by professional traders to define when the market is “oversold” or “overbought. Those two values will tell you when it’s either good or bad timing to enter or exit the market.
RSI analyzes the previous periods of price closings and defining a range in which price was moving in the period of 14 days. The range represents the value of 100 in which values below 30 are considered “oversold” and values above 70 are considered “overbought”. Once the indicator hits one of those values traders should be ready to close their position in order to avoid the potential trend reversal that will lead to additional losses.
Problem #3 – Build a trading system
Even though we’ve discussed only technical indicators you are more than welcome to go through trendlines that are being widely used by almost everyone on the market. You can even create strategies based on trendlines only like trendline breakout strategy.
Once you’ve figured out how and what indicators to use you will need to combine all of them into one trading strategy with defined rules which will cover: when to enter a position when to exit it, what positions to consider for entries, and why. After you got all of your problems solved and the trading strategy complied you will be able to start. But no, you won’t start trading you will start backtesting your strategy. You will have to find specific charts that you will test your strategy on. It can be simply done by scrolling the chart back to some specific date and apply your strategy to it by adding long or short positions.
In the end, apply the results and see if you are satisfied with them. A good trading strategy should give you an average of 50-60% win rate and around 20% of annual returns under the terms of good risk managed.
Conclusion
Trend trading strategies are the most profitable and yet the safest strategies on the market in a long run. You won’t be able to win when the whole market is losing and at the same time it will be hard to lose when the whole market is winning. Follow the trend, because the trend is your friend. Learn the new ways of implementing old indicators and create your own strategy that will allow you to make money on a stock market with ease. Good luck!